Recent years have seen much discussion about the effectiveness and fairness of Australia’s current rules for taxing discretionary trusts. These trusts are very popular in Australia and are widely used for holding investments, conducting businesses and succession planning.
However, a recent ATO-commissioned study that highlights several problems with trust taxation rules, together with changes proposed by the Labor opposition ahead of the upcoming federal election, may finally see trust tax reform become a reality.
A key feature of discretionary trusts is the ability to distribute income on a “discretionary” basis, which means no beneficiary has a particular entitlement to any income or capital assets in the trust and the trustees can make distributions at their discretion.
Importantly, distributions are generally taxed at the individual marginal tax rate of the beneficiaries, enabling tax-effective “income splitting” strategies to direct income to those on lower marginal tax rates. While this offers considerable planning flexibility, there are some concerns about the taxation advantages obtained through the use of these trusts, and certain corners of the community are agitating for reform.
A recently released report authored by RMIT University and commissioned by the ATO, Current issues with trusts and the tax system, highlights the extent of trust use in Australia. According to the report, the number of trusts in Australia increased by almost 700% between 1990 and 2014. Notably, around 33% of all Australian trusts are discretionary trusts engaged in trading (business) activities, which the report says is unique compared with most other countries. Another 40% are discretionary trusts used for holding investments.
The report identifies three key risk areas posed by trusts that may adversely affect tax revenues and undermine community confidence in the tax system:
- A fundamental design issue in our trust tax laws where the calculation of tax liabilities relies on concepts that can sometimes be manipulated by the trustees simply by exercising certain powers in the trust deed, giving those trustees the legal ability to influence the tax outcome.
- Related to the above point, mismatches between the economic benefits actually received by beneficiaries and the tax outcomes. This does not accord with the general principle that tax outcomes should follow economic benefits.
- Administrative challenges for authorities in identifying trusts and tracing trust income.
The report also focuses on risks associated with “complex distributions”, which may involve arrangements such as multiple trust structures (or “chains” of trusts) that make it difficult to identify ultimate beneficiaries, and questionable distributions to entities such as low-taxed or tax-preferred entities where someone other than that beneficiary receives the actual benefit of the distribution.
Is change on the horizon?
There has been talk for a number of years about the need to reform trust taxation, and change may finally be afoot. The Labor party announced in mid-2017 that, if elected, it would introduce a standard 30% minimum tax rate on all discretionary trust distributions to adult beneficiaries in a bid to curb “aggressive tax minimisation” strategies. Where a higher tax rate would apply under the normal marginal tax scales, the higher rate would apply. This reform would only apply to discretionary trusts (not “fixed” trusts) and there would be specific exclusions for certain types of trusts such as farm trusts, charitable trusts and testamentary (deceased estate) trusts.
Although the full technical detail of this proposal is not yet known, the introduction of a minimum 30% rate on distributions clearly presents a crack-down on the income-splitting strategies that are so popular today.
Do you operate a discretionary trust?
As we approach a federal election, it will be crucial to stay abreast of any further policy announcements on trusts, including any transitional arrangements that might apply should Labor win government and implement its reforms. In that event, we can assist businesses and investors who operate in discretionary trusts to consider their structuring options, taking into account the full detail of the new laws, the beneficiaries’ needs for asset protection and succession planning, and the tax implications of transferring to any new structure. Contact our office at any time to discuss tax planning for your structures.